Three terrible Italian ‘gaps’

Yesterday we got confirmation that Italy feel back to recession in the second quarter of the year (see more here). In this post I will take a look at three terrible ‘gaps’ – the NGDP gap, the output gap and the price gap –  which explains why the Italian economy is so deeply sick.

It is no secret that I believe that we can understand most of what is going on in any economy by looking at the equation of exchange:

(1) M*V=P*Y

Where M is the money supply, V is money-velocity, P is the price level and Y is real GDP.

We can – inspired by David Eagle – of course re-write (1):

(1)’ N=P*Y

Where N is nominal GDP.

From N, P and Y we can construct our gaps. Each gap is the percentage difference between the actual level of the variable – for example nominal GDP – and the ‘pre-crisis trend’ (2000-2007).

The NGDP gap – massive tightening of monetary conditions post-2008 

We start by having a look at nominal GDP.

NGDP gap Italy

We can make numerous observations based on this graph.

First of all, we can see the Italian euro membership provided considerable nominal stability from 2000 to 2008 – nominal GDP basically followed a straight line during this period and at no time from 2000 to 2008 was the NGDP gap more than +/- 2%. During the period 2000-2007 NGDP grew by an average of 3.8% y/y.

Second, there were no signs of excessive NGDP growth in the years just prior to 2008. If anything NGDP growth was fairly slow during 2005-7. Therefore, it is hard to argue that what followed in 2008 and onwards in anyway can be explained as a bubble bursting.

Third, even though Italy obviously has deep structural (supply side) problems there is no getting around that what we have seen is a very significant drop in nominal spending/aggregate demand in the Italian economy since 2008. This is a reflection of the significant tightening of Italian monetary conditions that we have seen since 2008. And this is the reason why the NGDP gap no is nearly -20%!

Given this massive deflationary shock it is in my view actually somewhat of a miracle that the political situation in Italy is not a lot worse than it is!

An ever widening price gap

The scale of the deflationary shock is also visible if we look at the development in the price level – here the GDP deflation – and the price gap.

Price gap Italy

The picture in terms of prices is very much the same as for NGDP. Prior to 2007/8 we had a considerable level of nominal stability. The actual price level (the GDP deflator) more or less grew at a steady pace close to the pre-crisis trend. GDP deflator-inflation averaged 2.5% from 2000 to 2008.

However, we also see that the massive deflationary trends in the Italian economy post-2008. Hence, the price gap has widened significantly and is now close to 7%.

It is also notable that we basically have three sub-periods in terms of the development in the price gap. First, the ‘Lehman shock’ in 2008-9 where the price gap widened from zero to 4-5%. Then a period of stabilisation in 2010 (a similar pattern is visible in the NGDP gap) – and then another shock caused by the ECB’s two catastrophic interest rate hikes in 2011. Since 2011 the price gap has just continued to widen and there are absolutely no signs that the widening of the price gap is coming to an end.

What should be noted, however, is that the price gap is considerably smaller than the NGDP gap (7% vs 20% in 2014). This is an indication of considerably downward rigidity in Italian prices. Hence, had there been full price flexibility the NGDP gap and the price gap would have been of a similar size. We can therefore conclude that the Italian Aggregate Supply (AS) curve is fairly flat (the short-run Phillips curve is not vertical).

The Great Recession has caused a massive output loss in Italy

In a world of full price flexibility the AS curve is vertical and as a result a drop in nominal GDP should be translated fully into a drop in prices, while the output should be unaffected. However, as the difference between the NGDP gap and the price indicates the Italian AS curve is far from vertical. Therefore we should expect a major negative demand shock to cause a drop in prices (relative to the pre-crisis trend), but also a a drop in output (real GDP). The graph below shows that certainly also has been the case.

Output gap Italy

 

The graph confirms the story from the two first graphs – from 2000 to 2007 there was considerably nominal stability and that led to real stability as well. Hence, during that period real GDP growth consistently was fairly close to potential growth. However, the development in real GDP since 2008 has been catastrophic. Hence, real GDP today is basically at the same level today as 15 years ago!

The extremely negative development in real GDP means that the output gap (based on this simple method) today is -14%! And worse – there don’t seems to be any sign of stabilisation (yesterday’s GDP numbers confirmed that).

And it should further be noted that even before the crisis Italian RGDP growth was quite weak. Hence, in the period 2000-2007 real GDP grew by an average of only 1.2% y/y – strongly indicating that Italy not only has to struggle with a massive negative demand problem, but also with serious structural problems.

Without monetary easing it could take a decade to close the output gap  

The message from the graphs above is clear – the Italian economy is suffering from a massive demand short-fall due to overly tight monetary conditions (a collapse in nominal GDP).

One can obviously imagine that the Italian output gap can be closed without monetary easing from the ECB. That would, however, necessitate a sharp drop in the Italian price level (basically 14% relative to the pre-crisis trend – the difference between the NGDP gap and the price gap).

A back of an envelop calculation illustrates how long this process would take. Over the last couple of years the GDP deflator has grown by 1-1.5% y/y compared a pre-crisis trend-growth rate around 2.5%. This means that the yearly widening of the price gap at the present pace is 1-1.5%. Hence, at that pace it would take 9-14 years to increase the price gap to 20%.

However, even if this was political and socially possible we should remember that such an “internal devaluation” would lead to a continued rise in both public and private debt ratios as it would means that nominal GDP growth would remain extremely low even if real GDP growth where to pick up a bit.

Concluding, without a monetary easing from the ECB Italy is likely to remain in a debt-deflation spiral within things that follows from that – banking distress, public finances troubles and political and social distress.

PS An Italian – Mario Draghi – told us today that the ECB does not think that there is a need for monetary easing right now. Looking at the “terrible gaps” it is pretty hard for me to agree with Mr. Draghi.

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“God forbid that our policy should ever work”

This is Mario Draghi at the ECB’s press conference yesterday:

“Meanwhile, inflation expectations for the euro area over the medium to long term continue to be firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2%. Looking ahead, the Governing Council is strongly determined to safeguard this anchoring.”

You got to ask yourself why you would ease monetary policy if you don’t want inflation expectations to increase. And ask yourself if the market will believe this will work if the ECB is so eager to say that the policy will not increase inflation expectations.

It all just feel so Japanese – pre-Kuroda…

HT Nicolas Goetzmann

 

The ECB is way behind the curve (the one graph version)

The ECB is today widely expected to introduce a number of measures to ease monetary conditions in the euro zone and it seems like the ECB is finally beginning to recognize the serious deflationary risks facing the euro zone.

But how far behind the curve is the ECB? There are a lot of measures of that, but if we look at the ECB’s own stated goal of 2% inflation then we will see that the ECB has basically failed consistently since 2008.

Below I look at the the level of the GDP deflator (which I believe is a better indicator of inflation than the ECB’s prefered measure – the HCIP inflation).

Price gap ECB

I think the graph very well illustrates just how big the ECB’s policy failure has been since 2008. From 1999 to 2008 the ECB basically kept the actual price level on a straight 2% path in line with its stated policy goal. However, since 2008 GDP deflator-inflation has consistently been well-below the 2%. As a result what I here call the price gap - the percentage difference between the actual price level and the 2% path – has kept on widening so the gap today is around 4%.

This is a massive policy mistake – and this is why the euro zone remains in crisis – and given the fact that we are basically not seeing any broad money supply growth at the moment the price gap is very likely to continue to widen. In fact outright deflation seems very likely if the ECB once again fails to take decisive action.

What should be done? It is really easy, but the ECB is likely to make it complicated 

At the ECB in Frankfurt they are happy to repeat Milton Friedman’s dictum that inflation is always and everywhere a monetary phenomenon. So it should be really simple – if you have less than 2% inflation and want to ensure 2% inflation then you need to create more money. Unfortunately the ECB seems to think that it is in someway ‘dirty’ to create money and therefore we are unlikely to see any measures today to actually create money.

Most analysts expect a cut in ECB’s deposit rate to negative territory and maybe a new LTRO and even some kind of lending scheme to European SMEs. But all of that is basically credit policies and not monetary policy. Credit policy has the purpose of distorting market prices – and that shouldn’t really be the business of central banks – while monetary policy is about hitting nominal variables such as the price level or nominal spending by controlling the money base (money creation).

The ECB needs to stop worrying about credit markets and instead focus on ensuring nominal stability. So to me it is very simple. Today Mario Draghi simply should announce that the ECB has failed since 2008, but that that will now change.

He should pre-commit to bringing back the price level to the ‘old’ trend within the next two years and do that he should keep expanding the euro zone money base (by buying a basket of GDP weight euro zone government bonds) until he achieves that goal and he should make is completely clear that there will be no limits to the expansion of the money base. The sole purpose of his actions will be to ensure that the price level is brought back on track as fast as possible.

Once the price level is brought back to the old trend it should be kept on this 2% trend path.

How hard can it be?

PS Yes, I fundamentally would like the ECB to target the nominal GDP level, but targeting the GDP deflator price level would be pretty close to my preferred policy.

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Mr. Draghi you have not delivered price stability. Now please do!

The ECB is very proud of its 2% inflation target. The problem is just that it is not hitting it.

According to the ECB price stability is defined as “inflation rates below, but close to, 2% over the medium term”.

Today the ECB published it’s new inflation and growth forecasts. The ECB now forecasts 1.4% inflation in 2013 and 1.3% in 2014. That might be below, but it is certainly not close to 2%. In fact inflation has been nowhere close to 2% for five years (!) if you look at the GDP deflator rather than HCIP inflation.

So how does the ECB response to its own forecast that it will fail in deliver price stability in both 2013 and 2014? Well, by saying everything is just fine and no monetary easing is needed.

No further comments are needed – its just depressing…

PS don’t tell me that euro zone inflation is low because of a positive supply shock. In 2011 the ECB nearly killed the euro by hiking interest rates twice in response to a negative supply shock.

PPS with M3 growth just above 3% is it pretty easy to conclude that the euro zone is heading for deflation sooner or later.

A simple monetary policy rule to end the euro crisis

It is extremely depressing. After about half year of calm in Europe – mostly due to the efforts of the Federal Reserve and the Bank of Japan – European policy makers have once again messed up and the euro crisis is back on top of the headlines in the financial markets. It is time for the ECB to finally take bold actions and end this crisis once and for all. And no I don’t suggest anymore bailouts or odd credit policies and new weird policy instruments. I have a much simpler suggestion and I am pretty sure it would end the crisis very fast.

My suggestion is that the ECB immediately issues the following statement:

“Effective today the ECB will start to undertake monetary operations to ensure that euro zone M3 growth will average 10% every year until the euro zone output gap has been closed. The ECB will allow inflation to temporarily overshoot the normal 2% inflation. The ECB has decided to undertake these measures as a failure to do so would seriously threatens price stability in the euro zone – given the present growth rate of M3 deflation is a substantial risk – and to ensure financial and economic stability in Europe. A failure to fight the deflationary risks would endanger the survival of the euro.

The ECB will from now on every month announce an operational target for the purchase of a GDP weighted basket of euro zone 2-year government bonds. The purpose of the operations will not be to support any single euro zone government, but to ensure a M3 growth rate that is comparable with long-term price stability. The present growth rate of M3 is deflationary and it is therefore of the highest importance that M3 growth is increased significantly until the deflationary risks have been substantially reduced.

The announced measures are completely within the ECB’s mandate and obligations to ensure price stability and financial stability in the euro zone as spelled out in the Maastricht Treaty.”

The ECB used to have a M3 reference rate. It is time to reintroduce it. In fact it is needed more than ever. So Mario Draghi what are you waiting for? And no you don’t have to ask the Bundesbank for permission.

PS See here to see why the M3 growth target should be 10%.

Time to end discretionary monetary policy!

This week has been nearly 100% about monetary policy in the financial markets and in the international financial media. In fact since 2008 monetary policy has been the main driver of prices in basically all asset classes. In the markets the main job of investors is to guess what the ECB or the Federal Reserve will do next. However, the problem is that there is tremendous uncertainty about what the central banks will do and this uncertainty is multi-dimensional. Hence, the question is not only whether XYZ central bank will ease monetary policy or not, but also about how it will do it.

Just take Mario Draghi’s press conference last week – he had to read out numerous different communiqués and he had to introduce completely new monetary concepts – just take OMT. OMT means Outright Monetary Transactions – not exactly a term you will find in the monetary theory textbook. And he also had to come up with completely new quasi-monetary institutions – just take the ESM. The ESM is the European Stability Mechanism. This is not really necessary and it just introduce completely unnecessary uncertainty about European monetary policy.

In reality monetary policy is extremely simple. Central bankers can fundamentally do two things. First, the central bank can increase or decrease the money base and second it can guide expectations. It is really simple. There is no reason for ESM, OMT, QE3 etc. The problem, however, is that central banks used to control the money base and expectations with interest rates, but with interest rates close to zero central bankers around the world seem to have lost the ability to communicate about what they want to do. As a result monetary policy has become extremely discretionary in both Europe and the US.

That need to change as this discretion is at the core the uncertainty about monetary policy. Central bankers therefore have to do two things to get back on track and to create some kind of normality. First, central banks should define very clear targets of what the want to achieve – preferably the ECB and the Fed should announce nominal GDP targets, but other target might do as well. Second, the central banks should give up communicating about monetary policy in terms of interest rates and rather communicate in terms of how much they want to change the money base.

In terms of changes in the money base the central banks should clarify how the money base is changed. The central bank can increase the money base, by buying different assets such as government bonds, foreign currencies, commodities or stocks. The important thing is that the central banks do not try to affect relative prices in the financial markets. When the Fed is conducting it “twist operations” it is trying to distort relative prices, which essentially is a form of central planning and has little to do with monetary policy. Therefore, the best the central banks could do is to define a clear basket of assets it will be buying or selling to increase or decrease the money base. This could be a fixed basket of bonds, currencies, commodities and stocks – or it could just be short-term government bonds. The important thing is that the central bank define a clear instrument.

This would remove the “instrument uncertainty” and the ECB or the Fed would not have to come up with new weird instruments every single month. Rather for example the Fed could just start at every regular FOMC meetings to state for example that “the expectations is now that without changes in our policy instrument we will undershoot our policy target and as a consequence we today have decided to use our policy instrument to increase the money base by X dollars to ensure that we will hit our policy target within the next 12 months. We will increase the money base further if contrary to our expectations policy target is not meet.” 

In this world there would be no discretion at all – the central bank would be strictly rule following. It would use its well-defined policy instrument to always hit the policy target and there would be no problems with zero bound interest rates. But most important it would allow the financial markets to do most of the lifting as such set-up would be tremendously more transparent than what they are doing today.

Today we will see whether Ben Bernanke want to continue distorting relative prices and maintaining policy uncertainty by keeping the Fed’s highly discretionary habits or whether he want to ensure a target and rules based monetary policy.

PS a possibility would of course also be to use NGDP futures to conduct monetary policy as Scott Sumner has suggested, but that nearly seems like science fiction given the extreme conservatism of the world’s major central banks.

Draghi and European dollar demand – an answer to JP Irving’s puzzle

Yesterday, ECB chief Mario Draghi hinted quite clearly that monetary easing would be forthcoming in the euro zone. In fact he said the ECB would do everything to save the euro. However, something paradoxical happened on the back of Draghi’s comments. Here is JP Irving on his blog Economic Sophisms:

“Something interesting happened yesterday. The Euro strengthened  after Draghi hinted at easier policy. Usually when policy eases, a currency will weaken. However, the euro is so fragile now that easier money lifts the currency’s survival odds and outweighs the normally dominant effect of a greater expected money supply.  I had wondered what would happen to the EUR/USD rate if, say, the ECB announced a major unsterilized bout of QE, we may have an answer. This may be a rare instance where money printing—to a point—strengthens a currency.”

I can understand that JP is puzzled. Normally we would certainly expect monetary easing to mean that the currency should weaken. However, I think there is a pretty straightforward explanation to this and it has to do with the monetary linkages between the US and the euro zone. In my post Between the money supply and velocity – the euro zone vs the US from earlier in the week I described how I think the origin of the tightening of US monetary conditions in 2008 was a sharp rise in European dollar demand. When European investors in 2008 scrambled to increase their cash holdings they did not primarily demand euros, but US dollars. As a result US money-velocity dropped much more than European money-velocity, but at the same time the ECB failed to curb the drop in money supply growth. The sharp increase in dollar demand caused EUR/USD to plummet (the dollar strengthened).

What happened yesterday was exactly the opposite. Draghi effectively announced that he would increase the euro zone money supply and hence reduce the risk of crisis. With an escalation of the euro crisis less likely investors did move to reduce their demand for cash and since the dollar is the reserve currency of the world (and Europe) dollar demand dropped and as a result EUR/USD spiked. Hence, yesterday’s market action is fully in line with the mechanisms that came into play in 2008 and have been in play ever since. In that regard, it should be noted that Mario Draghi not only eased monetary policy in Europe yesterday, but also in the US as his comments led to a drop in dollar demand.

Finally this is a very good illustration of Scott Sumner’s point that monetary policy tends to work with long and variable leads. The expectational channel is extremely important in the monetary transmission mechanism, but so are – as I have often stressed – the international monetary linkages. In that regard it is paradoxical that University of Chicago (!!) economics professor Casey Mulligan exactly yesterday decided to publish a comment claiming that monetary policy does not have an impact on markets. Casey, did you see the reaction to Draghi’s comments? Or maybe it was just a technology shock?

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Related posts:

Between the money supply and velocity – the euro zone vs the US
International monetary disorder – how policy mistakes turned the crisis into a global crisis

The reason Mario Monti is beginning to sound (very) desperate

When the eurocrat Mario Monti became Prime Minister last year we were told that he was the man to turn around the Italian economy. We were told that technocrats would do the job rotten and incompetent politicians were not able to do. However, the eurocrat Papademos did not last long in Greece and now Mario Monti is beginning to sound rather desperate. On Thursday he told reporters that EU policy makers had one week to save the euro. That is somewhat of a stern warning from somebody who is supposed to be a cool-headed technocrat.

Why this sudden desperation from Monti? Well, it is pretty simple – Italian nominal GDP is declining sharply, while Italian funding costs are increasing sharply day-by-day. With NGDP declining rapidly the public debt-to-GDP ratio obviously is exploding and as investors know that the ECB has not shown any willingness to curb the decline in NGDP then Italian debt as share of GDP is likely to continue to increase no matter how many budget cuts and tax increases the Italian parliament passes. It is very simply – without growth in NGDP the Italian government will fast become insolvent.

Therefore, it is not really Angela Merkel Mario Monti should be asking for help to solve the crisis, but rather his namesake and countryman ECB chief Mario Draghi. The ECB can end this crisis by introducing a determined policy to curb the drop in euro zone NGDP (or rather to increase NGDP markedly). On the other hand if Draghi does not act then it might very well be that Monti is right about his warnings.

PS Meanwhile Monti’s predecessor is having other ideas (remember Italy never defaults – Italy inflates…) and it is not the first time.

Draghi “We never pre-commit” – well isn’t that exactly your problem?

I don’t particularly feel an obligation to comment on today’s ECB monetary policy announcement and I think my regular readers have a pretty good idea about how I feel about the ECB these days. However, ECB chief Mario Draghi pulled out a traditional ECB phrase on the outlook on monetary policy that I think pretty well describes the ECB’s problem and why we are in mess we are in.

Mario Draghi said – as Trichet used to before him – that “we never pre-commit” to any particular future monetary policy action. My reply to Draghi would be isn’t that exactly your problem!?

Yesterday, I did a post on the importance of the expectational channel in monetary policy and how the Chuck Norris effect or what Matt O’Brien has called the Jedi mind trick can be a tremendous help in the conduct of monetary policy. If you have a credible target and credible reaction function the markets are likely to do most of the lifting in terms of monetary policy implementation. However, when Draghi is saying that the ECB is not pre-committed on monetary policy then he is effectively saying “We don’t want to tell you what your target is and we are not going to reveal our reaction function”. That of course means that the ECB will get no help from Chuck Norris (the markets) to implement policy.

On the other hand if Draghi had said “The ECB is pre-committed to use whatever instruments in our arsenal to achieve our nominal targets and will do unlimited amounts of buy or selling of assets to achieve these targets” then Draghi would not have to do much more. Chuck Norris would help him so he could spend more time golfing.

However, you get the feeling that the ECB on purpose wants to be ambiguous on what monetary policy action it will take and what it want to target. From a monetary policy perspective this makes no sense at all. Why would a central bank do something like that? What monetary theory is telling the ECB that it is a good idea not to pre-commit?  I think the answer is nothing to do with monetary theory and everything to do with public choice theory. The special ECB lingo like “we never pre-commit” seem to be designed to ensure the legitimacy of the ECB. The lingo is simply rituals that should convince us that the ECB is a legitimate institution and it’s powers should not be questioned. See more on this topic here.

Evans-Pritchard on the Latin Bloc’s “monetarist avenger”

The resident market monetarist at Britain’s Daily Telegraph Ambrose Evans-Pritchard has a comment on European monetary policy under the leadership of the new ECB chief Mario Draghi.

Here is Ambrose:

“Those of a monetarist bent are less alarmed by fiscal contraction (than Keynesians). I have no doubt that monetary stimulus a l’outrance – the classic remedy of Britain’s Ralph Hawtrey, Sweden’s Gustav Cassel and America’s Irving Fisher in the 1930s – can counter the effects of fiscal tightening if conducted in the right way. The debt-to-GDP burden falls faster that way and deflation is averted, a lesson that Japan forgot.

The great question is whether Mario Draghi is embarking on just such a policy, covertly, through his Long-Term Repo Operations (LTRO), starting with €489bn in three-year loans to 523 banks December and to be followed by another blast in February.

The LTRO is not entirely a free lunch. It is replacing funding that has dried up, but to the extent that banks in Italy, Spain, France and Portugal use the cheap money to buy government bonds at rich yields – the Sarkozy “carry trade” – they are not lending to business, as newly bankrupt Spanair can attest…

…Yet, monetarists think Draghi is quietly pulling off a remarkable coup. “This is stealth QE: the impact is dulled because they are not making it clear what they are trying to do, but in the end it may ultimately be as powerful as QE in America and Britain,” said Lars Christensen from Danske Bank.

Tim Congdon from International Monetary Research said Mr Draghi had already boosted total credit to banks from €580bn to €832bn since early November, entirely reversing the Trichet tightening of late 2010.

This may rise to nearer €1.5 trillion this year. While it does not lead to a rise in broad money at first (just the monetary base), it is likely to feed through over coming months in complex secondary effects. “My conclusion is that the Draghi bazooka is such an aggressive example of monetary easing that Eurozone M3 growth will run at 5pc or more [annualized] in mid and late 2012.”

“I (Tim Congdon)remain sceptical about the viability of the European single currency in the long run, but the day of the execution has been postponed once again,” he said.

If Mr Draghi really is the Latin bloc’s monetarist avenger, the Germans will find out soon enough. It is Germany that will overheat, inflate, and suffer a “Latin” credit bubble as EMU’s wheel of fortune turns. Europe’s crisis will take on a whole new political turn. But that is a chapter for tomorrow.”

Needless to say I tend to agree with most things that Ambrose says (and I also find it hard to disagree with Tim). I particularly like that Ambrose mentions Hawtrey, Cassel and Fisher.

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Update: For those interested in my view on fiscal policy see here.

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